Definition: “It is a letter of open request by a bank or other financial institution to a prospective borrower, for an agreed amount and for a definite or indefinite period. It enables the borrower to draw a bill of exchange on the bank which is automatically accepted”.
Letter of credit is an open letter of request by a bank requesting a person to lend a certain sum of money to the person named therein and promises that the sum in question will be paid by itself. In other words, the bank guarantees the payment of the debt.
The request may be made by a banker or any individual, but mostly it is the banker which issues it.
Explanation: It is a document issued by a banker or other financial institution to a borrower who is allowed to draw a bill of exchange on the institution and is accepted automatically. The letter of credit is used in local and foreign trade. The buyer requests his bank to open an L/C addressed to the seller in the foreign country or other city within a country. The exporter or seller obtains the payment by presenting all necessary documents which have been accepted and returned by the importer or buyer. The L/C becomes irrevocable when the seller is informed of the credit.
The L/C states the use of the bill, the amount, period, and documents attached.
It consists of an undertaking by a bank that the bill of exchange drawn on it will be honored.
KINDS OF LETTER OF CREDIT (L/C)
Letter of credit can be divided into two broad categories.
- Letters of commercial credit.
- Letters of travelers facility.
1. Letters of Commercial Credit: These credits are used for business purposes. They are of the following types:
Confirmed or Irrevocable Credit: By issuing this type of credit the bank gives an undertaking to accept and pay the bill of exchange drawn on it.
Unconfirmed or Revocable Credits: When the bank does not give an undertaking to accept and pay the bill drawn on it, it is called unconfirmed credit. It simply states that the bank is willing to honor the bill drawn under the credit unless the credit is cancelled.
Acceptance Credits: When the credits provide for bills to be accepted by the bank instead of the importer, it is called acceptance credit. Such credits save time and risk of loss of the bill during transit.
Document Credits: Such credits provide for bills to be accompanied by necessary documents including railway receipts, shipping papers, insurance receipt, and bill of lading.
Clean or Non Documentary Credits: When the credit does not require attaching necessary documents with the bill, it is known as clean or non-documentary credit.
Omnibus Credits: It is granted to those exporters who possess high credit standing. They can draw full amount on a bank against the pledge of a general lien on their goods.
Fixed Credits: When credits are available for a fixed total amount either in one or several bills, it is called fixed credits.
Revolving Credits: Where credits are automatically renewable under certain conditions, they are known as revolving credits.
Transferable Credit: Where fixed credit allows its holder to transfer his right to draw against them to another person, it is known as transferable credit.
Divisible Credit: Where the credit allows its holder to transfer drawing rights in parts of the total amount of credit to the other party, it is known as divisible credit.
Letters of Travellers Facility: Such letters are issued to the travelers. It is risky to carry money in foreign country and may be lost, stolen, or robbed. These letters are substitute to their money, and can be cashed at the designated bank at the place of visit. These are of the following types:
Travellers commercial L/C
Limited letter of credit
Traveller’s Cheque: These cheques ar drafts which are issued to tourists. These are used for noncommercial purpose and these are drawn by the holder on the issuing bank for round sums. These are specialized cheques made available to overseas travellers and converted into the currency of the country of destination. Travellers’ cheques are issued in several denominations in a local or foreign currency. The issuing bank accepts the return of unused cheques at a little commission.
At the time of issue, the holder sings the cheque in the presence of the manager of the issuing bank and then the cashing bank; and the two signatures must agree.
Travellers cheques can only be issued after fulfilling exchange control regulations set by the central bank of a country.
Circular Cheque / Credit: Banks issue such cheques to their agents, branches, or correspondents in foreign countries to sell them to visitors to the country of the issuing bank. For instance, Habib Bank, Karachi issues circular cheques to its branch in London to sell them to resident Pakistanis who want to visit Pakistan. These cheques are issued under the foreign exchange law of Great Britain.
Travellers’ Commercial Letter of Credit: These cheques are issued to businessmen who want to make purchases abroad but are reluctant or afraid to carry with them huge amount in cash. These cheques are accompanied by necessary shipping documents.
Limited Letter Credit: Unlike circular L/C which is useful in many countries at a time, the limited letter of credit is issued only on a branch or an agent of specified country. It is not useful in other places.
Circular or World-Wide Letter of Credit: This type of cheque is available with any of the bank’s correspondents and agents abroad.